III. Introduction to Financial Programming - IMF eLibrary

III. Introduction to Financial Programming

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Nature of Financial Programming

A financial program is a comprehensive set of policy measures designed to achievea given set of macroeconomic goals. These goals could simply be to maintain agiven level of economic performance. More often, however, the policies aredesigned to eliminate disequilibrium between aggregate domestic demand andsupply, which typically manifests itself in balance of payments problems, risinginflation, and low output growth.

The term "financial program" is commonly used to describe adjustment programswhich support use of Fund resources, but may also be applied in the absence of aFund arrangement. It emphasizes the importance of monetary, fiscal, and exchangerate policies in controlling domestic demand and correcting balance of paymentsdisequilibria. In addition—as a practical consideration—financial data to monitor theimplementation of such policies are typically available on a more timely basis thanother economic data. However, it should be underscored that financial programsalso incorporate the effects of other policy instruments, most prominently thoseaimed at increasing aggregate supply.

Where macroeconomic imbalances exist, some form of correction (or adjustment)will ultimately be necessary in order to bring claims on resources in line with thoseavailable. If deliberate policy actions are not taken, the adjustment is likely to bedisorderly and inefficient. For example, reserves may be depleted and creditors maybecome unwilling to lend further to a country. A drastic cut in imports could ensue,with consequent negative effects on economic growth and welfare. Thedistinguishing feature of a financial program is that it seeks to achieve an orderlyadjustment, through the early adoption of corrective policy measures, and throughthe provision of appropriate amounts of external financing. This should minimizelosses in output and employment during the adjustment period while eventuallyleading to a balance of payments position that is sustainable.

Sustainability of the balance of payments may be assessed with reference to theevolution of the external current account balance over the medium term. Whilecircumstances may vary from one country to another, in general terms it may besaid that a sustainable current account position is one that can be financed on alasting basis with the expected capital inflows and which, at the same time, isconsistent with adequate growth, price stability, and the country's ability to servicefully its external debt servicing obligations.

A financial program thus needs to be set in a forward looking time framework. Theconcept of medium-term is not a rigid one; medium-term scenarios have generallyconsidered a time horizon of at least five years. Typically, programs for theforthcoming year are worked out in considerable detail because of the moreimminent need to formulate a comprehensive package of policy measures and themore readily available and reliable information. Forecasts of the more distant yearsare less detailed, often focusing on the broad implications for external adjustment,and are by their nature less certain.

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A Basic Financial Programming Framework 1 /

An integrated system of macroeconomic accounts, as described in Chapter II,covering national income and expenditure, as well as financial flows and associatedstocks, is essential in the construction of financial programs. These accountsprovide the information needed to assess the performance of the economy and theneed for policy adjustment. They also provide a framework and consistency checksfor policy analysis. The accounting relationships in the framework highlight the factthat any sector's spending beyond its income must be financed by the savings ofother sectors, and that such excess spending by an entire economy is possible onlywhen financed from external sources.

To be of interest to policy makers, the accounting framework must becomplemented by the specification of a set of behavioral relationships. Theserelations indicate the typical reaction or response of some of the variables includedin the accounting framework to changes in other variables. These behavioralrelationships together with the accounting identities form a schematic quantitativerepresentation, or "model", of the relevant economic processes. This frameworkcan be used to assess the changes in policy variables, i.e., variables that are underthe authorities' control, needed to achieve given policy objectives for such variablesas inflation and the balance of payments, which are endogenously determined.

The design of programs is subject to many uncertainties and difficulties. Behavioralrelationships may be difficult to identify and estimate with any precision and theymay vary across countries and over time depending on institutional, political, andother factors. Moreover, when major policy shifts and structural reforms are beingundertaken, behavior in the post-reform period may differ greatly from historicalpatterns. Analysis may be further complicated by problems of assessing the timingof policy effects, the impact of expectations on behavioral responses, and theinterrelations among measures in complex policy packages. Finally, assumedchanges in exogenous variables, which are determined independently of theprocesses illustrated in the model, may prove to be incorrect.

1/ A more detailed review of a framework for financial programming can be found in "Theoretical Aspects of the Design ofFund-Supported Adjustment Programs," IMF, Occassional Paper No.55, September 1987.

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Policy Content of Programs

Discussion of the policy options can be framed around two accounting identitiesdiscussed in Chapter II. Specifically:

GDI - A = CA (1)

and

CA + AFI = AR (2)

where:

GDI = gross national disposable incomeA = domestic absorption, i.e., residents' expenditure on domestic

and foreign goods and servicesCA = external current account balanceAFI = net capital inflowsAR = the change in net official international reserves

Equation (1) indicates that an improvement in the external current account balancerequires either an increase in a country's output or a reduction in its expenditure.Accordingly, adjustment policies may aim to increase output and reduce domesticexpenditure to allow a greater proportion of output to be devoted to exports and alower proportion of expenditures to imports.

Equation (2) is the balance of payments identity: any excess of absorption overincome, as reflected in a current account deficit, must be financed either by capitalinflows or a drawdown of reserves.

1. Demand management policies

Demand management policies primarily aim at reducing domestic demand (orabsorption) when an external current account deficit and/or inflationary pressuresneed to be reduced. These primarily comprise monetary, fiscal and incomespolicies, but other measures such as an exchange rate devaluation may also includeexpenditure reducing elements.

In many instances the source of excess domestic demand is the fiscal sector.A combination of a reduction in public sector outlays and an increase in revenuesmay be called for. However, simple measures of the government's overall balancemay not give adequate indication of the demand effects of fiscal policy.In particular, how the overall balance is financed is important in determiningprogram impact.

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Domestic absorption can also be dampened by restraining monetary aggregates—forexample, by introducing measures to change the volume of credit extended to theprivate sector and/or the public sector. Monetary and fiscal policies are linked tothe extent that the banking system provides net financing (whether positive ornegative) to the public sector. For example, a narrowing of the public sector deficitthat reduces the need for bank financing (or increases recourse to nonbank financingof a given deficit) will directly affect the balance sheet of the banking system.Other things being equal, this would result in a decline in monetary aggregates.

2. Expenditure-switching policiesMany programs seek to complement reductions in absorption by expenditure-switching measures and, in particular, exchange rate policy. By changing therelative price of foreign and domestic goods facing both residents andnonresidents—i.e., from a resident's perspective, increasing the price of a country'sexports and imports relative to the price of domestic goods—an exchange ratedevaluation aims to: (1) increase the global demand for domestic goods and serviceswhile reducing residents' domestic absorption by discouraging imports, and(2) from the supply side, raise incentives to produce goods for export or thatcompete with imports. By redirecting output from domestic absorption to theexternal sector, the negative effects of demand restraint on output can beminimized.

Other examples of expenditure-switching policies include removal of price controlsand quantitative trade restrictions.

3. Structural policiesStructural policies aim at the enhancement of supply to close the absorption-outputgap. These may be broadly divided into: (1) policies designed to raise output fromexisting resources through increased allocative efficiency; and (2) policies to expandthe productive capacity of the economy. While in practice it is difficult todistinguish policies serving these two purposes, conceptually one can think of theformer category including all measures to reduce the distortions that drive a wedgebetween prices and marginal cost. Such distortions can arise, for example, fromprice controls, imperfect competition, taxes and subsidies, and trade and exchangerestrictions.

Increases in capacity require policies that encourage investment and savings.Examples include maintaining realistic interest rates, reducing fiscal deficits,reallocating fiscal expenditures toward activity with the strongest benefits forgrowth and economic development, and policies that tend to guide new resourcesto investments with the highest rates of return. By their nature, substantial time maybe needed for structural policies to show results.

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4. Financing options

The ability to attract capital inflows to sustain an external current account deficitwithout running into debt service problems depends, among other filings, on thejudgement of creditors as to the creditworthiness of the country and how efficientlythe borrowed funds are used. In particular, if foreign borrowing is used to financeinvestments which generate sufficient returns to finance the repayment of suchfunds, then debt servicing problems should not arise. Debt servicing problems,however, may be expected when resources are used inefficiently or to supportdomestic consumption only. In addition, changes in world economic conditions maysignificantly affect the availability and affordability of funds. For example, risinginterest rates in the early 1980s exacerbated the debt servicing difficultiesexperienced by many developing countries.

Considerations relating to external debt management have become an increasinglyimportant part of program design. Key debt relationships need to be monitored ona medium-term basis, under alternative assumptions about the country's ownpolicies and the behavior of the external environment, including interest rates.Development of such medium-term scenarios has represented an important aspectof the Fund's work in stabilization programs.

Financing may also take the form of a reduction in international reserves. Howeversuch possibilities are limited by the size of the initial stock of reserves.

In addition to the above sources of voluntary external financing, in extremecircumstances some countries may finance external deficits by accumulatingarrears. Arrears, however, constitute payment restrictions and are thereforecontrary to Fund policies. In addition, they undermine creditor confidence and,therefore, complicate relations with external creditors.

* * * *

Policies, to be effective, need to be constructed and implemented in a mutuallysupportive manner. For example, a depreciation of the exchange rate, if notsupported by demand restraint, may fail to redirect resources to the external sectorwhile raising the inflationary pressures in the economy.

In designing the objectives of a policy package, account should be taken of trade-offs between different objectives and, thus, of the policies needed to achieve them.Listed below are several examples. A depreciation of the exchange rate, aimed atreducing the external current account deficit, will also raise the domestic currencycosts of servicing the external debt. In the absence of other measures, this will raisethe fiscal deficit. Policies aimed at sharply reducing inflation may not be consistentwith strong output growth in the short-run, particularly if prices are not fullyflexible downward. Balance of payments surpluses may result in excessive monetarygrowth and inflationary pressures. Supply side measures to liberalize trade mayresult in an initial deterioration in the overall balance of payments position as thepent up demand for imports is unleashed; the removal of price controls is likely toraise inflation, at least initially.

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Steps in Economic Forecasting

Preparation of a financial program requires an assessment of economic problemsand the quantification of a coordinated set of policy instruments to achieve a givenoutcome. It requires completion of the major sector accounts to provide aninternally consistent, and feasible, scenario of developments that could result fromadopting a given package of policy measures. Given the linkages among theaccounts, an iterative, rather than sequential, procedure is likely to be required toensure a consistent program.

The workshop series is developed by sector, with the intention of providingparticipants with an understanding of the issues and methods needed for forecastingindividual sectors. However, while the focus at any point in time will be on aparticular sector, the overall aim is to develop a consistent macroeconomicprojection of the Hungarian economy in 1990, and its implications for the medium-term balance of payments position. A first step is the development of the so-calledthe reference scenario, broadly based on the assumption that policies remainunchanged from the recent past. The reference scenario is intended to indicatewhether the existing problems are likely to be resolved by themselves, to remainthe same, or even worsen.

An assessment of what constitutes an unchanged policy stance involves elements ofjudgement. For example, if budgeted expenditures have regularly been overrun bywide margins, then continuation of this practice could be considered to constituteone element of an unchanged policy stance. Similarly, if the exchange rate has beenadjusted according to the differential between domestic and trading partners'inflation rates, then adoption of this rule could be another element of unchangedpolicies. In assessing the policy stance, it is important that the coverage becomprehensive, including fiscal, monetary (including interest rate), exchange rate,and structural issues.

Reference scenarios may differ for a variety of reasons. These may includedifferences in the relative importance attached to the various economic problems;in interpretation of what constitutes an unchanged policy stance; in assessment ofthe policy trade-offs; and in the methods used in forecasting. While formulation ofthese scenarios necessarily involves a considerable element of judgement, it needsto be underscored that repeated cross-checking of sectoral forecasts is required toensure overall behavioral and accounting consistency.

The reference scenario, serves as a benchmark for elaborating a normative programscenario. This scenario would be based on an explicit policy package designed toachieve a desired set of objectives. Comparison of reference and program scenarioswould indicate the expected impact of the policy package.

Below are some suggested general guidelines for preparing a financial program.The more technical details are treated separately in the individual workshops.

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1. Evaluate economic problems

An understanding of the economic, institutional and socio/political structure of theeconomy and recent economic developments is essential for forecasting and policyanalysis. The type of policy instruments available should also be identified.A diagnosis should be made regarding:

(1) the nature of the economic imbalance. If the problem is expected to beshort-lived (cyclical, seasonal, etc.) all that may be required is some bridgefinancing or a temporary drawdown of reserves. More permanent imbalanceswill likely need to rely more heavily on a package of adjustment measures.

(2) the source of the imbalance. If at root of the problem is a large fiscaldeficit, corrective measures will need to be implemented in this area. If thecause is external, for example a terms of trade deterioration, an exchangerate adjustment is more likely to be considered as part of a package toimprove current account prospects.

(3) the seriousness of the imbalance related to, among other things, thedimensions of the problem and availability of financing. The more urgentlythe imbalances need to be addressed, the more drastic adjustment measuresthat will be needed.

2. Identify developments that are outsidethe authorities' control

External sector forecasts involve interrelationships with the rest of the world andmust, therefore, take account of developments in the world economy, includingprospects for commodity and other foreign trade prices, world interest rates, andoutput and demand growth in partner and competitor countries. Forecasts of thesevariables can be obtained from various private, government, and international tradeorganizations. Chapter V on balance of payments forecasting summarizes forecastsin the Fund's World Economic Outlook that may be of relevance when makingprojections for the Hungarian economy. Nevertheless, a considerable degree ofuncertainty must underlie these forecasts. It is thus useful to undertake sensitivityanalyses of the effects of deviations from projected levels of some of the moreimportant external variables.

3. Set preliminary targets and developpolicy package

The differences between the reference scenario and the program scenario should benoted. In a reference scenario, the preliminary targets are derived as an outcomeof the assumption of a continuation of the existing policies. By contrast, in aprogram scenario targets are first set and then policy measures are adopted to meet

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these targets. The outcome of the reference scenario should provide a basis forestablishing appropriate targets for the program scenario.

Targets are typically set for the balance of payments—in terms of the currentaccount balance and/or the level of international reserves—prices, and output. Theyshould be consistent with a viable balance of payments position, in the mediumterm, as well as with growth and inflation objectives.

4. Prepare sectoral forecasts

Given the iterative nature of the exercise, there are many possible approaches andstarting points in developing a scenario. The approach taken in the forthcomingworkshops is to start with a preliminary price and output projection, followed byforecasts for the balance of payments, fiscal sector and finally the monetary sector.However, at various stages there will be a need to iterate among the sectoralforecasts to ensure accounting and behavioral consistency and the feasibility ofachieving the stated targets. This is highlighted by the following examples.

Assume that a preliminary set of projections or targets has been made for prices,real output, and the change in net international reserves. The implications of theseprojections for the external sector can be verified by forecasting values for exportsand capital flows and deriving imports residually. However, in a second round thederived import figure must be made consistent with the demand for imports at theprojected level of nominal output (a behavioral relationship). If, for instance, thedemand for imports is greater than the value of imports derived residually, someadjustment must be made. The basic choices include:

(1) increasing the foreign exchange available to support a higher level ofimports, either by adopting policies to raise export receipts or by seeking outadditional financing;

(2) lowering the initial projection or target for net international reserves toallow for a higher level of imports;

(3) reducing the initial projection or target for nominal output to lower thedemand for imports; and

(4) a combination of some of the above.

A similar iterative procedure would be carried out for the fiscal and monetarysectors. For instance, projections for prices, output, and net foreign assets underlieany estimate of net banking system domestic credit. If the implied bank creditextended to the government sector is insufficient to cover the estimated fiscal deficitthen the following options are available:

(1) introduce a package of fiscal measures to reduce the public sectordeficit, which may result in lower nominal output growth;

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(2) redirect credit from the private sector to the government sector, whichmay also have a dampening effect on nominal output growth;

(3) raise additional external financing, which has obvious balance ofpayments implications;

(4) increase nonbank domestic financing, which may have interest rateimplications;

(5) increase bank credit extended to the government, accepting the likelynegative effects on inflation and/or the balance of payments; and

(6) a combination of some of the above.

In general, abstracting from some of the peculiarities and discrepancies evident inany data set—some of which were discussed in Chapter II for the case ofHungary—the following accounting relations should hold:

• output from the expenditure side should be based on fiscal data forgovernment consumption and investment and on external data for net foreignexpenditure;

• government recourse to banking system credit, as shown in the fiscaldata, should be consistent with the change in net domestic credit to thegovernment, as reported in the monetary accounts; and

• government recourse to external financing, as shown in the fiscal data,and changes in the net foreign asset position in the balance sheet of thebanking system should have counterpart entries in the capital flows of thebalance of payments.

Key behavioral relationships that need to be considered include:

• the demand for money and its relationship to nominal output and othervariables

• the demand for imports and its relationship to nominal output and othervariables

• the relationship between private sector bank credit and privateinvestment and imports

5. Review desirability of use of Fund resources

This step is relevant for the program scenario. A decision that a program shouldbe supported by use of Fund resources requires that performance criteria be set.Performance criteria provide a direct link between program implementation and thedisbursement of the Fund's resources. Failure to observe the performance criteria

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results in interruption of the member's drawings under an arrangement. Dependingon the causes and nature of the deviations, either a waiver, or modification, maybe granted to permit a resumption of drawings, or a new understanding may needto be reached.

Performance criteria and other monitoring devices are intended to be limited tothose necessary to evaluate implementation of the program so as to avoid excessiveinvolvement of the Fund in the details of economic policy making.

The following are the most commonly used types of performance criteria:

• a ceiling on domestic bank credit expansion;

• a sub-ceiling on net domestic bank credit to the government, or thenonfinancial public sector;

• ceilings on nonconsessional external borrowing, including short andmedium-and long-term debts;

• a floor on net international reserves; and

• understandings that there will not be new, or an intensification ofexisting, exchange and import restrictions.

Bank credit ceilings may be set at either the level of the monetary survey or themonetary authorities' accounts. The former provides immediate consistency withtargets (through the inflation and growth rate used in predicting the demand formoney and the change in net foreign assets), but leaves open the measures theauthorities may take to limit monetary aggregates. Placement of the ceilings at thelevel of the monetary authorities' accounts has the advantage of dealing withaggregates more subject to the authorities' control, but means that consistency withtargets depends on the stability of the assumed money supply function.

Other kinds of policies may, where appropriate, also be subject to performancecriteria. Important in this context have been additional understandings affecting theexchange and trade system, including measures relating to exchange rate policy andto the reduction or elimination of external payments arrears.

Disbursements of Fund monies can also be subject to completion of a review, whichtypically monitors structural and other policies that may not be amenable toquantitative performance criteria.

Prior actions, i.e., implementation of policy measures seen as critical to theeffectiveness of an adjustment program prior to approval of a Fund arrangement,may also be required. Such actions are particularly important where severeimbalances exist, or in cases where the record of policy implementation has beenweak.

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Issues for Discussion

1. On the basis of Chapters I and II, discuss the main economic problemsfacing Hungary at end-1989. This review should identify the main macroeconomicand structural weaknesses and provide some initial assessment of the causes, size,and urgency of the economic difficulties.

2. Assess the policy stance of the authorities' in the recent past. Consider theeffectiveness of these policies in achieving major economic objectives. Identify thepolicy instruments available to the authorities.

3. Review in broad terms the main assumptions that will underlie the referencescenario.

4. What are the major factors affecting economic performance that you considerto be outside of the authorities' control?

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